Loan Eligiblity

Agenda
1. 2. 3. 4. Theory of Bank Credit Analyzing Bank Credit Risk Credit Process Credit Derivatives

Lemon Problem: Used Cars

Two indistinguishable (to buyers) types of cars: lemons (often breaking down) and creampuffs (never breaking down). If buyers will pay $3000 for a creampuff and $3000 for a lemon. Sellers will part with a creampuff for $2500 and part with a lemon for $1000. One third of cars are creampuffs and two thirds are lemons.

Symmetric Information
If borrowers and sellers both can easily distinguish lemons from creampuffs, there is a simple market solution.
Buyers will pay $3000 for a creampuff and $2000 for a lemon and sellers will be happy to sell.

If neither borrowers nor sellers can distinguish between types, there is still a solution.
Buyers could pay the average of their values ($2000)+($3000) = $2,333. This would be higher than the average value to sellers: ($1000)+($2500) = $1500.

Asymmetric Information
What happens if buyers cant distinguish between types but sellers can? Buyers might be willing to offer $2,333 for a car of unknown type, but owners of creampuffs would value their car more highly than that. Only lemon owners would sell at that price. Buyers would have no reason to offer more than $2000. Only lemons will be bought and sold. No market for creampuffs will exist.

Lemon Problem: Bond Market

Some firms have risky prospects (lemons) and some firms have safe prospects (creampuffs). Bond buyers cannot distinguish between them. They offer bond prices which are an average of the price of creampuff bonds and lemon bonds. [Another way of putting this is that interest rates are an average of creampuff and lemon rates]. Potential borrowers with creampuff prospects may finance their own projects.

Raising Interest Rates May Not Compensate for Risks in Bond Markets
Only borrowers with lemon prospects will join bond markets. Typically we think bond buyers might take riskier assets if they were offered a higher interest rate. But if savers demand a higher interest rate under asymmetric information this will only exacerbate the lemon problem if higher interest rates drive creampuff borrowers out of the market.

Adverse Selection: The Bond Market

Consider a bond market with three types of bond sellers. 1. Safe: Financing a safe, low-return project. Can only pay 7.5% interest rate but will never default. 2. Speculative: Financing a high risk/high return project will pay a 15% interest rate, but a high probability of default. 3. Crooks: Will offer to pay any interest rate, but will never repay. Assume that 75% of bond issuers are safe, 20% of bond issuers are speculative, and just 5% are crooks.

Bond Buyers
Bond buyers will pay:
97 for a discount bond issued by a borrower identified as safe; 90 for a bond issued by a borrower identified as speculative 0 for bond issued by a crook.

If they cannot distinguish, they will pay a value equal to the expected value of the pool. In this pool, the expected value is (.75*97)+(.2*90)+(0.05*0) = 90.75 which implies a yield to maturity of i = .102.

Borrower will Pay Share at Most Safe 0.75 7.50% Speculative 0.2 15% Crook 0.05 Anything Unknown Type

Investor will pay at Most 97 90 0 90.75

or get at least 1.030928 3.09% 1.111111 11.11% 1.101928 10.19%

Bond market breaks down!

Rate of interest offered by uninformed investor is attractive to speculative borrowers but to expensive for safe borrowers. They will drop out of the market. As bond buyers begin to realize the riskiness of pool is changing, they will reassess price that they will pay for bonds. The pool will now be 80% speculative and 20% crooks. The expected value of bonds in this pool is (.8*90)+(.2*0)=72 implying a yield of i = .3889. This is too much for speculative borrowers. Only crooks will stay in the market. Ultimately the bond market will disappear.

Adverse Selection
Actions that lenders take to protect themselves from consequence of a lack of information lead to a worsening of the risk pool. In the extreme case, adverse selection can cause an entire market to disappear.

Business of Banking & Comparative Advantage

Comparative advantage of banking. Banking exists as a specialist in acquiring information and eliminating adverse selection problems. A key comparative advantage of banks is their ability to evaluate information on borrowers. Banking business should attempt to make best use of that advantage.

Credit Risk: the risk that a borrower will not pay back interest or principal on a loan.
Evaluating Bank Credit Risk History of Credit Performance (Charge-offs) Future expected losses (non-performing loans, types of lending, diversification) Current Strength of bank preparation (reserves, earnings coverage).

Net Charge-offs to Loans

3.00% 2.50%

2.00% 1.50%

1.00% 0.50%

0.00% Total loans & leases Total real estate loans Commercial & industrial loans Loans to individuals All other loans & leases (including farm)

2007

2006

2005

2004

Statistic on Depository Institutions

Stages of Bad Loans

Past Due Loans: Loans for which contracted payments have not been made, but which still are accruing interest.
More than 90 days past due is Nonperforming Loans

Nonaccrual Loans: Loans that are habitually past due and no longer accruing interest. Total Noncurrent = Past Due + Nonaccrual Charge-offs: Loans written off as uncollectable Recoveries: Sums later collected on loans written off. Net Chargoffs = Charge-offs - Recoveries

Past Due Loans (Contractual Payment not Made)

90 Days

Non Performing Loans

Recovery

Non Current Loans

Full Payment Not Expected

Net Chargeoffs

Collection Process Non-accrual Loans

Total Chargeoffs

Uncollect ible Loans Written off

Non Current Assets to Loans

1.80% 1.60% 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% Total loans & All real estate Commercial & leases loans industrial loans Loans to individuals All other loans & leases (including farm) Commercial real estate loans not secured by real estate

2007

2006

2005

2004

Statistic on Depository Institutions

Measuring a Banks Credit Risk/Key Ratios

Loans are assets with the most credit risk (also the most profitable). Other types of assets are typically more transparent and have less risk of default. Large quantities of loans make banks riskier. Higher Loans to Assets means higher risk. Rapid expansion of credit means banks may not be discriminating Higher Loan Growth Rate means higher risk
Measure banks chargeoffs, loan composition, nonperforming & non current loans, earnings coverage, loan loss allowances on page 8 & page 9 of UBPRs.

Composition of a Banks Loan Portfolio

Some loans are riskier than others, so a high share of loans in risky categories involves higher risk.
Banks concentrate on real estate lending which tends to have very low default rates.

An undiversified portfolio also exposes a bank to risk. Concentration in the property market exposes the bank to systematic risk of property collapse.

Protection
Banks protect themselves from credit risk with reserves allocated to loan losses. Measures of these reserves measure banks protection against credit risk
1. Loan Loss Allowance/Loans 2. Loan Loss Allowance/Net Chargeoffs

Banks earnings are also a protection against losses Earnings Coverage = (NII-Burden)/Net Chargeoffs

Protection from Bad Loans US Commercial Banks, 2004

7 6 5 4 3 2 1 0 2004 Loan Loss/Net Charge Offs 2003 2002 2001 Loan Loss/Gross Loans (%)

Earnings/Net Charge Offs

Source: SDI, FDIC Statistics on Depository Institutions, FDIC

Credit Process
I. II. III. IV. Credit Policy Business Development and Credit Analysis . Credit Execution Loan Review

I. Credit Policy
Loan Policy Loan Culture
1. Values Driven Risk Averse 2. Current Profit Different High risk/return lending, Cyclical Profits 3. Market Share Driven Low returns, large scale.

Written Loan Policy

FDIC recommends, A loan policy should address:
General fields of lending Normal trade area Lending authority of loan officers and committees Responsibility of the board of directors in approving loans Guidelines for portfolio mix, risk diversification, appraisals, unsecured loans, and rates of interest Limitations on loan-to-value, aggregate loans, and overdrafts Credit and collateral documentation standards Collection procedures Guidelines addressing loan review/grading systems and the allowance for loan and lease losses Safeguards to minimize potential environmental liability

Source http://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune _up.html

Business Development & Credit Analysis

Marketing Find customers Loan Interview Meet potential borrower and evaluate for character and sincerity Evaluation of Business Gather information about the borrowers business. Credit Analysis: Numerical analysis of a businesses financial condition Evaluation of Collateral Adequacy: Check whether collateral that backs loans is of value commensurate with loan.

Credit Scoring Models

Banks use numerical models to evaluate the credit of borrowing firms. Seminal model was the Z-score model of Edward Altman

Z (1.2 WC ) (1.4 RE ) (3.3 ROA) (0.6 Equity ) (.999 AT )

WC Working Capital to Assets RE: Retained Earnings to Assets ROA: EBIT/Assets

Equity: Market to Book Ratio AT: Asset TurnoverSales to Assets

Above 3, bankruptcy unlikely; below 1.8 bankruptcy likely.

FICO
In USA, Fair Isaac Corp. develops models that evaluate consumer households likelihood of default. FICO or similar score used for consumer credit
Late payments The amount of time credit has been established The amount of credit used versus the amount of credit available Length of time at present residence Negative credit information such as bankruptcies, charge-offs, collections, etc.

In Hong Kong, recent relaxation of some rules governing sharing of consumer credit information.

5 Cs of Credit
1. Character Past history of borrower in paying bills. 2. Capital Borrowers Wealth Position 3. Collateral possession by the borrower of assets that back up the loan. 4. Conditions - trends and volatility of the borrowers industry 5. Capacity Legal Standing and ability of the borrower to generate loan payments on a consistent basis

III. Execution
Documentation
Loan Agreements
Restrictive Covenants

Perfecting Claims to Collateral

Parts of a Typical Loan Agreement

The Note: Specifies the principal and the interest and the timing of repayment. Collateral: Specifies assets assigned and terms under which lender takes possession of assets. Covenants Borrower Guarantees. Events of Default: Exact conditions under which a loan is considered in default.

Loan Covenants
A central part of the credit process is the monitoring of borrowers. Banks restrict borrowers use of funds in the loan agreement.
Affirmative Covenants. Actions that the borrower must take. Maintaining liquidity and equity as measured by financial ratios, maintaining insurance, file financial reports, pay taxes, etc. Negative Covenants. Actions that the borrower cannot take. Taking on new debt, buying or selling assets, paying excessive dividends, paying excessive salaries or bonuses, etc.

IV. Credit Review

Monitor Covenants Loan Review Process
Ex post evaluations of lending evaluation

Loan Workout
Process for dealing with defaulting creditors

Credit Derivatives
Risk Management Tools Used to transfer risk from one party to another. Credit Swaps A bank with credit risk exposure will pay X basis points per year and counter-party will make payment if there is a pre-determined credit event such as default or credit downgrade, etc. Total Return Swap: Bank with credit risk will pay the income stream from risky debt while counter-party will pay some fixed rate to bank..

Credit Swap
Bank A Fee Payment

Payment if negative credit event

Bank B

Total Return Swap

Bank A Loan and Principal

Loan and Principal

Intermediary

Loan and Principal

Loan and Principal Bank B

Credit Derivatives
Global Credit Derivatives 14000 12000 10000

US$ Trillion

8000 6000 4000 2000 0 1H01 2H01 1H02 2H02 1H03 2H03 1H04 2H04 1H05

Source: www.creditderiv.com

Extra Reading
HKMA Benefits of Sharing Positive Consumer Credit Data B. Hirtle, NY FED, 2007, Credit Derivatives and Bank Credit Supply BIS 2005 Credit Risk Transfer